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posted on 03 September 2016

Markets: Soaring Or Bubbling?

Written by , Difference Group

In recent weeks, US markets have reached record highs. However, fundamentals do not justify the rallies. Prepare for a rough ride.

Click for larger image at Zero Hedge.

Recently, three US stock indexes achieved record heights. For the first time since 1999, the Dow Jones Industrial average (18,576), the Standard & Poor's 500-stock index (2,184) and the Nasdaq composite index (5,232) all peaked at all-time highs on the same day.

After a slowdown early in the year and another from the UK Brexit referendum, it has been all manna from heaven to investors.

The real question is, if major advanced economies are lingering amid secular stagnation and growth is decelerating in emerging economies, why are the markets soaring and how long will they do so?

Irrational exuberance déjà vu

Analysts have pointed out that the US stocks look relatively better than alternatives. Others attribute the positive equity outlook to rising energy prices after their plunge, and the OPEC talks about reducing the oversupply of oil and stabilizing the market. Finally, equity traders argue that record highs can herald excellent trading months.

The contrarian view might be that, despite secular stagnation, US economy seems to be doing well, primarily because the Fed has deferred a rate hike, while the European Central Bank (ECB) and the Bank of Japan (BOJ) maintain ultra-low rates and engage in further quantitative easing.

Moreover, energy prices remain fragile. The Organization of the Petroleum Exporting Countries (OPEC), which has dominated crude oil prices since the mid-70s, will meet in September to respond to a renewed dip. The hope is that members would set new production limits to raise prices. Yet, in the past meetings, nothing has come out of talks.

Certainly, record highs may precipitate lucrative trading, but what goes up tends to come down eventually. When the three stock indexes reached their record highs in 1999, it paved way to a historical collapse between 1999 and 2001 as the dot-com bubble came to an end.

Have the fundamentals drastically changed? As far as analysts are concerned, earnings season has been better than anticipated but not as great as recent rallies would suggest. For a long-term view, let's look at CAPE (cyclically adjusted price-earnings ratio), which is used to assess likely future returns from equities.

The average CAPE value for the 20th century was 15.2, which translated to an average annual return of 6.6% over the next 20 years. CAPE values below the figure resulted in lower returns, and vice versa. It has been over 25 only in 1929, 1999 and 2007, each of which led to major market drops. Today, it is around 26 - almost as nine years ago.

Beware of the fall

Recent rallies suggest that investors' appetite for risk is climbing. Instead of defensive stocks (consumer staples, telecoms, utilities), they have been boosting cyclicals (i.e., materials, technology, financials). That has pushed demand for equity driving markets higher. Investors are not rushing in to the market because of improved fundamentals - but for a fear of missing out.

What about bonds? The historical pattern between US stocks and Treasury bonds is that they move in opposite directions. When investors seek for risk, they buy stocks and sell bonds, and vice versa. Yet, today both US stocks and US Treasuries have been trading near all-time highs. If government bonds even in Germany, not to speak of Japan, have negative yields, US bonds look attractive, even if rates fall under 1.4%.

Despite recent rallies, downward risks are real. In addition to further deceleration in emerging markets, potential changes in the coming weeks include the Fed's post-Jackson Hole September meeting, the subsequent OPEC talks, monetary exhaustion in Europe or the letdown of Abenomics in Japan.

A closer look into the markets suggests caution.

An earlier version of this article was released by Shanghai Daily on August 23, 2016.

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